Goldman's Take On Bernanke's Defense

Just out from Jan Hatzius of Goldman

BOTTOM LINE: Fed Chairman Bernanke delivers a) a strong defense of the Fed’s renewed monetary easing, b) a fairly explicit endorsement of near-term fiscal expansion (coupled with longer-term consolidation) in the United States, and c) a fairly explicit plea to reduce current account imbalances via exchange rate appreciation in emerging market economies.

MAIN POINTS:

1. In a speech at the European Central Bank in Frankfurt to be delivered on Friday, Chairman Bernanke provides a strong defense of the Fed’s decision on November 3 to purchase another $600 billion (bn) in longer-term Treasury securities.  He notes that “on its current economic trajectory the United States runs the risk of seeing millions of workers unemployed or underemployed for many years.  As a society, we should find that outcome unacceptable.”  Compared with his most recent public comment on the Fed’s decision – an op-ed article in the Washington Post on November 4 – he also strengthens slightly the assessment that inflation is now too low, saying that it is “below” as opposed to “a bit lower than” the mandate-consistent rate. 

2. He takes issue with the term “quantitative easing” on the grounds that the impact of the policy does not work via the quantity of bank reserves but instead via the impact of the Fed’s asset holdings on the bond term premium.  (We agree, but will nevertheless continue using the shorthand “QE2” for simplicity.)  The distinction is one that Fed officials have long made, but in this case it is part of a broader attempt to demystify the November 3 decision and emphasize the similarities with conventional monetary easing decisions.

3. The chairman is relatively explicit in his support for expansionary fiscal policy as well, albeit coupled with longer-term consolidation.  Specifically, he says that “a fiscal program that combines near-term measures to enhance growth with strong, confidence-inducing steps to reduce longer-term structural deficits would be an important complement to the policies of the Federal Reserve.”  Admittedly, the phrasing “near-term measures to enhance growth” does leave some wiggle room, but this is nevertheless a strong hint that Fed officials would like to see accommodative fiscal policies in the near term.

4. Finally, the speech includes a strong plea for exchange rate appreciation in economies with large current account surpluses.  Bernanke argues that the large-scale capital inflows experienced in the surplus countries – which many EM policymakers have blamed on inappropriately easy monetary policy in the United States – instead reflect incomplete currency adjustment in the surplus countries, which in effect offers investors a one-way currency bet.  Moreover, he argues (and presents evidence) that the currency adjustment is incomplete because EM policymakers have intervened aggressively in the foreign exchange markets.  Bernanke closes by noting similarities between the current situation of incomplete exchange rate adjustment and the flaws in the international monetary system prior to the Great Depression of the 1930s, when the United States and France ran large surpluses and refused to let the resulting inflows of gold feed through into a higher domestic money supply.  Although he is careful to say that he is “certainly not predicting a new Depression,” that is a strong warning coming from a Fed chairman.